Debt Pay Off Before a Home Purchase
Updated: Jul 3
I often get questions from buyers about how to pay off debts before a home purchase. Here are my top tips, in order of importance.
Disclosure: I'm Not a CPA or CFP
Disclosure: Please keep in mind that I am not a certified public accountant and that one is best consulted prior to taking action based on tax implications. I am not a certified financial planner. Any tax-advantaged discussion, investment discussion, or other primarily financially focused discussion is Adam's unprofessional opinion.
General advice:
Keep up with minimum payments across all accounts.
If you don't, your credit can drastically decrease in such a way that can't readily be removed for years. Decreased credit can increase the interest rates you incur, especially for new debt.
Establish a budget & stick to it if you don't already have one that you stick to.
Effective budgeting & sticking to it is critical to getting out of debt, no matter how much or how little you make. Intuit Mint is a good free resource.
Any benefit of credit card points or cashback is severely outweighed by interest on credit card debt if your actions have demonstrated that you have difficulty with overspending. Credit cards have a proven track record of people tending to spend more than they would otherwise. If you have credit card debt, it's generally best to shift to spending exclusively on debit cards, not even considering going back to credit cards unless you develop a proven budgeting & savings track record for at least 3 years after you're out of credit card debt. I say that as someone with over 30 credit cards and a Facebook group I started of around 4k people at the time of this publication on credit cards and travel hacking. To keep your credit cards active if they're not carrying a balance, do a charge for around $5/month, with automatic payments in full. Also, establish alerts so that if anyone ever spends fraudulently on your accounts, you get a text update. If there's only an option for email updates, use this workaround for getting texts.
Get educated on credit.
Credit education can be especially helpful for increasing your credit score which can decrease the rates of any future debts.
Here you can get your full credit reports once a year free.
At Experian.com there is a free version for your report on an ongoing basis & Experian FICO credit score.
Creditkarma.com has free Transunion & Equifax information, which can be helpful, but don't rely on the score, as it's a "Vantage Score", also known as "FACO score" by some, which can be 100 points different than what the lender might pull at times since it's a completely different model to a higher degree than FICO scores from the same bureau.
Here is a list of credit counseling agencies available in VA. If using an agency, some may intentionally drag their feet if they are paid on a monthly basis rather than being paid a flat fee or per disputed item.
If possible, increase your income.
If you have the time, increasing income with a side job or with your current work (whether via extra hours, diligent efforts, education, or otherwise) can be beneficial.
Get educated on taxes.
Some people can save hundreds if not thousands every year after getting better educated on tax avenues to do so, especially if you aren't familiar with taxes. A little time can save a lot of money, often much more than people's hourly wage or annual salary converted to an hourly amount.
Don't neglect warranties & insurance.
One of the most common ways that people get into debt is from not having adequate savings to cover unforeseen circumstances in life when they don't have the right warranties &/or insurance to cover those expenses.
Auto insurance is something where if you can't afford to pay for a comparable car in cash, you may want to consider getting full insurance coverage if you currently only have liability, especially if you've caused a prior accident.
if you don't have medical insurance, I'd highly recommend getting at least some form of coverage.
If you have a history of short or long-term disability or think that you could be at risk, consider those insurance as well if you wouldn't have the savings to cover yourself adequately in the event that you no longer were able to work. In addition, be sure to pay your taxes and not underreport so that if you developed a long-term disability, you wouldn't shortchange yourself by getting less help from the government than you would receive otherwise. Be familiar with how much money you'd receive in the event of a long-term disability from social security. If you engage in high-risk activities that can put your health at risk, consider refraining until the point when you can acquire short/long-term disability coverage.
In some cases, you can even find free warranties or other assistance, such as free cell phone insurance & roadside assistance that can come with certain credit cards just by having the card. Knowledge is power in this arena. With cell phones, it's often best to also purchase a phone case for better protection.
Don't establish new "bad debt."
Avoid acquiring debt on unnecessary expenses, like boats, furniture, and otherwise.
If you're doing something like buying a new car every 3 years, consider shifting your habits. The most rapid depreciation vehicles experience is in the first 5 years, so older, reliable, low-mileage vehicles are a strong option. When you purchase a vehicle, be mindful of issues like depreciation rates for that vehicle type, typical maintenance expenses for that vehicle make (& model if possible), and miles per gallon, all of which are available in advance in many cases for models. If you need to purchase a car, try to save up as much as you can in cash so that the payment is lower for a downpayment if you need to have a loan at all and don't pay for it in cash. In some cases, the rate on car loans can be lower than what you get at banks. For instance, right now I have a car loan, but I put over 50% down, the car loan rate is <2% on a 3-year loan, I acquired a 5-year warranty, I average over 35 MPG on the SUV, I don't have to worry about replacing a battery since it's not a hybrid, and the rate I'm getting at banks is around 5% for a general savings account where I can take out money at any time without penalty and is FDIC insured. I might have the vehicle for 5 or 10 years before replacing it depending on factors like how many miles I'm putting on it. Try to have a car for 2-4 times as long as it takes to pay down the loan if you opt to get a loan instead of paying in cash. Especially if you have low credit, consider cash-only cars, since interest rates on auto loans will tend to be much higher for those with low credit. Focus more on what's needed than what's cosmetically appealing and comfortable.
Keep separate designated accounts for major fixed expenses w/ no monthly fees or transfer fees incurred.
In order to budget effectively, I recommend that you have multiple types of free accounts at multiple institutions & that you automatically have money transferred to those institutions soon after your paychecks hit as long as you receive the money from your paycheck at regular intervals. If possible, it's also nice to get multiple direct deposits going at multiple institutions. While some banks may allow for multiple accounts at a single institution, if you have all of your accounts at 1 institution, it is too easy to pass the money in between accounts. For instance, it's good to have money going to separate institutions for (most important in bold):
Your housing payment, car payment if applicable, & any other fixed expenses that don't fluctuate more than once a year (& be sure to have those dates in your calendar in case you need to make adjustments)
Fluctuating expenses that are critical and that you don't actively see being incurred, i.e. electric bill, water bill, sewer, gas, etc.
Highly fluctuating expenses that you should be watching closely for budgeting purposes in a checking account
Emergency Fund
Savings Fund
Investment Fund
Savings for taxes if you have your own business
Any tuition expenses
Home & vehicle maintenance fund
Health fund, especially if you have high medical expenses
Vehicle fund for your next vehicle if you currently own your vehicle without any payment
Mortgage fund if planning on purchasing a new property without selling your current home
Tax-advantaged funds (i.e. 529 plan if you plan to pay for your or your family's school at least in part, Health Savings Account if available via qualifications like a high deductible health insurance plan, etc.)
Effective banking includes different accounts for different purposes. I have some for high interest, some for cashback debit cards, 1 for unlimited ATM fee reimbursements, 1 for free cashiers checks & free money orders, 1 for free wire transfers, a few with many local branches and many without local branches, etc. I don't incur any monthly fees for any of my banks/credit unions & don't get charged for any transfers between my accounts. My highest APY for years has been over 6% on up to $1k and I have an APY of 5.02% as of 4/26/23 on an account that has a minimum of $1k to achieve that APY. See more under my banking section.
Avenues to consider to pay off debt:
Seek a specialist or group that specializes for direct assistance.
Debt consolidation specialists, credit repair specialists, financial planners, and others can help, though watch out for the fees. In some cases, especially if low-income &/or disabled, there are free options for assistance.
Here are some examples of nationally available charitable options for assistance to get out of debt:
https://scc.virginia.gov/pages/Consumer-Resources (primarily available nationally)
http://www.needhelppayingbills.com/html/help_paying_debt.html
Mortgage help: http://www.needhelppayingbills.com/html/help_with_mortgage.html
Here are some examples of local charitable institutions offering assistance to get out of debt:
http://www.needhelppayingbills.com/html/hampton_roads_catholic_chariti.html
http://www.debtfreeonline.com/ Some free & paid options. Non-profit located in Hampton. See their fees & free options here.
Consider the debt snowball.
The debt snowball approach (especially if a new personal loan would have a high rate) is a solid option after establishing a small $1k emergency fund if you don’t have one already as part of Dave Ramsey’s 7 Baby Steps.
Consider a debt consolidation loan.
An unsecured personal loan for debt consolidation after taking other steps to increase your credit if currently low (which will help the rates for the new loan to be lower) IF it would help you to save $ due to the interest rate on the new loan being lower than the composite rate of your existing debts.
If you have federal student loans, consider avoiding wrapping them into a debt consolidation loan. They receive special protections not available in many other cases, such as the many deferments that were made possible with no new interest due to Covid-19.
If you have a VA loan, consider having the seller help.
VA loans are the only typical mortgage that allows the seller to pay for buyer debt like they normally would closing cost assistance in addition to still being able to help with closing costs. If your debts are small enough & you are eligible for VA loans, that can help.
Consider 1 or a few credit cards with a 0% APR, but mind the risk of these if you don't have at least 6 months of proven budgeting/savings growth track record.
If considering a credit card with 0% introductory APR, watch out for balance transfer fees & whatever the ending interest rate might be (which is typically a variable rate) & keep in mind that depending on factors like the utilization rate of the credit card, their credit score may decrease (i.e. if there is a new high utilization rate that is higher than their prior revolving utilization) or increase (i.e. if they have maxed out credit cards beyond the limits and the new card would have a lower utilization rate than their current average revolving utilization rate). I typically don't advise going this route unless you can prove to yourself for 6 months that you can have substantive consistent savings growth that you can budget effectively enough to have a payment plan that gets this one paid down quickly. Often people will do these with good intentions, but then they don't have the discipline to pay it down or life happens and the savings they have is depleted by an unforeseen expense.
For more details on balance transfer cards with an initial 0% APR, no balance transfer fee, or a lifetime tenure of <10% APR for any initial balance transfers, go here.
If you already own a home, consider a home equity line of credit (HELOC).
If you are a future home buyer that already owns a home now, a HELOC is a solid option for debt consolidation if the interest rate would be lower than what you are paying now. That said, especially if your credit is already good, selling your home and buying another is a viable option in some cases without using a HELOC, because HELOCs incur closing costs & interest, even though HELOC interest is typically lower than that of unsecured debt.
Avenues to consider when purchasing:
Use a loan with no down payment & possibly no or limited closing costs.
Even for conventional buyers, there are options at times with no down payment required. Other options include USDA guaranteed or direct loans in rural areas, VA loans, & NACA (that is quite a hassle, but has the benefit of no down payment and no closing costs, though there will still be prepaids). Sometimes the lender can finance in the typical closing costs even if closing costs are typical.
Consider down payment assistance or another program to reduce home costs such as help with closing costs
There are a wide variety of programs available. Here are some examples such as the Good Neighbor Next Door program with effectively 50% off homes.
Consider tapping a retirement account, but some are better than others.
Consider a retirement account, but while some are user-friendly, like the principal from a Roth IRA after having the Roth IRA for at least 5 years, some, especially employer-sponsored plans, could limit future contributions and future match from your employer until the loan is paid off. If tapping an employer-sponsored plan, be sure to ask your employer about that before doing so, as they can vary greatly on the subject. I am not a CPA, my opinion should not be construed as tax advice, & a CPA is best consulted prior to doing so.